3AECO - Free Trade and Protection
2.
Free Trade and Protection continued
PROTECTION
• Protection occurs where governments prevent free trade in order to give an
artificial advantage to domestic firms when competing with foreign firms. Protection
reduces gains from trade.
• There are two main types of protection – those which target the prices of imports
(eg tariffs) or import-competing products eg subsidies) and methods which target
the quantity of imports (eg embargos and quotas) allowed into the country.
TARIFFS
A tariff is a tax on imported goods. It raises the price of imports and allows
domestic producers to raise their prices and expand their share of the domestic
market at the expense of foreign producers.
Examine the following diagrams to understand how tariffs work.
P
Sd
In a closed economy there are no imports. The
domestic market is dominated entirely by domestic
firms (Sd). Price to consumers = P who purchase
Q1 of the product.
P
Dd
Q
Q1
In a completely open economy, imports sell on the
domestic market at the world price = Pw. The domestic
market becomes part of the world market. Both domestic
goods and imports sell at the lower world price. At this
lower price consumers purchase more of the product
(Q2). Australian consumers are part of the world market.
With free trade the supply curve is horizontal, ie.
supply is perfectly elastic meaning the supply of
imports is unlimited at price Pw. Demand would
determine the actual level of imports. (In a small
economy like Australia, this is not an unrealistic
assumption, ie demand in Australia is too small a
proportion of global demand to influence price)
Protection
P
Sd
Pw
Sw
Dd
Q
Q2
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3AECO - Free Trade and Protection
With our tariff analysis we combine the previous two graphs.
P
Sd
P
Pw
Sw
Dd
0
Qd
Q
Q
3
Q
Q2
1
Market share of domestic (local) firms at price Pw - market share falls to 0Q3 from
0Q2 before free trade
Imports share of domestic market at Pw (0Qd2 – 0Q3)
When the Australian economy is open to free trade, price must fall from P to Pw. At
Pw consumers buy 0Q2 - consumers are better off. 0Q2 represents the Australian
market. However domestic firms lose market share to foreign firms. When the
market share of local firms falls due to cheaper imports, employment in the
domestic industry declines (structural UE).
When a tariff is introduced price rises from Pw to Pt (Pt = Pw + tariff).
P
Sd
P
Pt
Pw
Sw
Dd
0
Q
Q3
Q4
Q1
Q5
Q2
Domestic firms increase market share from 0Q3 to 0Q4. (Total revenue going to
domestic firms is Pt x 0Q4). Total market falls from 0Q2 to 0Q5 as consumption
contracts due to the higher price, ie. purchasing power (real income) falls. Not only will
demand contract in this protected market but the reduced purchasing power impacts
on other industries too. Imports are reduced because they are more expensive due to
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3AECO - Free Trade and Protection
the tariff. The tariff goes to the government which receives [(Pt-Pw) x (0Q5 - 0Q4)].
EFFECTS OF A TARIFF
• Domestic production rises → employment rises (protective effect) in the protected
industry.
• Consumers pay more (consumption effect) and have less choice.
• Trade declines - imports fall - exports will probably fall too due to retaliation and
rising costs of production for exporters due to tariffs on imported components and flow
on effects of tariffs in general (exporters can’t pass on cost increases to consumers) international competitiveness declines (trade effect). Lower real income means
consumers have less to spend on other goods and services → output and employment
fall in the rest of the economy.
• Government revenue rises although this depends on elasticity of demand for the
protected product.
• Resources are reallocated away from competitive, unprotected industries to less
competitive, protected industries. Protected firms consume more resources than they
would without protection. This means fewer resources available for unprotected firms
(ceteris paribus) → factor costs rise as prices are bid up in factor markets → reduced
economic activity and less employment growth generally outside the protected sector.
• Redistribution of income away from consumers and efficient producers to protected
domestic producers and their workers and government.
• Overall standards of living are lower and long term economic growth is stunted.

Assuming no structural change or reform, over time demand for protection increases
as world producers increase efficiency and lower unit production costs. Pw falls
requiring a higher tariff level to maintain the same output level in the protected
industry. The efficiency gap between domestic and foreign firms increases –
Australia’s competitiveness declines.
EFFECTS OF TARIFFS
Tariffs increase prices of imports and
domestically produced goods including
exports.
Protection assists
Local industries by guaranteeing them a
larger share of the domestic market. Allows
them to charge a higher price and provide
additional jobs.
Exporters and consumers pay more for
inputs and goods. Exporters can’t pass on
costs to foreign consumers.
Fewer exports - higher costs reduce competitiveness.
Consumers have less real income → reduces
consumption → hurts domestic firms in goods and
services sector. Trading partners may retaliate with
protective measures against our exports → less trade
hurts exporters.
Less growth → fewer jobs →lower
living standards.
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3AECO - Free Trade and Protection
Restructuring to cope with tariff reductions
When tariff protection is removed, domestic firms can respond in different ways.
They can do nothing, in which case their businesses, and employment in those
businesses decline, or they can accept tariff cuts and improve the efficiency of their
businesses and become more competitive. The motor vehicle industry is a classic
example of the latter response. It is now world class in its performance and to
illustrate the industry’s success, exports of motor vehicles and components grew
from just under $400 million in 1984 to about $5 billion in 2001. This was a result
of reducing tariffs on imported vehicles in a series of graduated cuts from 57.5% in
1988 to 5% in 2010. The industry has prospered as a result of tariff cuts! Look at
the tariff model below Price
Sd
Pt 1 - price before tariff cut
Pw - price with no tariff
Qd - domestic output with protection
Qd+m - total output including imports
Pt1
Pw
A reduction in the tariff will reduce price
towards the free trade price (Pw). Show this on
the model with a pencil. What happens to the
relative market shares of domestic firms and
imports?
Dd
domestic
output
imports
0
Qd 1
Q(d+m)1
Quantity
The diagram below shows the response of a dynamic industry as the tariff is reduced
(Pt1 to Pt2) as with the car industry in Australia. In the model, price falls closer to the
tariff free price (Pw). With economic reform the local industry becomes more efficient
and productivity rises (Sd shifts to the right) and the industry increases its share of
the market (Qdt1 to Qdt2). The Australian car industry has restructured and it now
exports a large part of its output.
Price
Sd1 with no reform
Sd2 with reform
Reduced tariff causes demand to expand. Some
of this is met by higher domestic output (0Qd2)
and some by more imports.
Tariff revenue to government falls (shaded box).
Pt1 = Price before tariff cut
Pt2 = Price after tariff cut
Pw = world or free trade price
Domestic output increases due to greater
efficiency and higher productivity (Qd 1 to Qd2)
Pt1
Pt2
Pw
Total market size increases from Q(d+m)1 to Q(d+m)2
Dd
domestic
output
0
Protection
imports
Qd 1 Qd2 Q(d+m)1 Q(d+m)2
Quantity
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3AECO - Free Trade and Protection
STUDENT ACTIVITY 2.3
Study the diagram above and answer the following questions.
Explain how restructuring in the car industry has enabled the industry to retain a
larger share of the car market than it would have had it not restructured.
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SUBSIDIES
STUDENT ACTIVITY 6.2
A subsidy is a payment made by government to domestic firms to encourage
production. The subsidy reduces the firm’s costs.
Price
S
Ss
Pw
imports
0
Q1
Q2
Q3
Quantity
Q1 = domestic firm’s share of market without subsidy.
Pw = price paid by consumers (free trade price).
Q2 = domestic firm’s market share with subsidy. Firm’s S curve shifts to right with a
subsidy reflecting reduced cost of production which is now partially borne by the
taxpayer. Domestic firm’s output rises from Q1 to Q2.
Q3 - Q2 = imports after subsidy to domestic firm.
EFFECTS OF A SUBSIDY
1. Consumers pay for subsidy through taxes.
2. Domestic firm expands → unemployment falls in that firm.
3. Transfer of income from taxpayers to protected firm and its workers.
4. Unlike a tariff, government receives no revenue - subsidy means there is less
money available to spend on other government programs (opportunity cost).
5. Foreign producers lose market share and income → less competition → less
incentive for local firms to improve efficiency. Retaliatory subsidies in other
countries may result if they can afford them - is unlikely in poor developing
countries who suffer most from subsidies in rich countries.
6. Preferable to a tariff because subsidy is paid for from taxes which are raised
largely from progressive income taxes whereas tariffs are regressive in their effect.
However still imposes costs on the community.
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3AECO - Free Trade and Protection
7. Misallocation of resources like with tariff → factor costs rise → reduces growth
potential in other more competitive areas of the economy. Damages international
trade.
Protection has definite long term costs.
Global experience shows clear benefits
when protective measures are
dismantled and trade is liberalised.
The negative consequences of protective subsidies is illustrated in the extract below
from the Australian Financial Review, 25/7/01. Read it carefully and think about
the issue of global income disparities.
Farmers in Third World countries and small landholders elsewhere are losing out to
nations that are subsidizing their agriculture sectors and dominating commodity
prices around the world.
... the global trade in farm and food products, ... accounts for nearly 11 per cent of
world merchandise trade.
But it is a business cruelly distorted and corrupted by a handful of mostly rich
countries around the world.
Every year, these nations pump nearly $US327 billion in taxpayer subsidies into
their agriculture sectors, producing grain and butter mountains and deadening
commodity prices around the globe.
Leading the spending spree is the European Union, which, according to OECD
figures, doled out $US90 billion in 1999, followed by Japan with $US60 billion and
the United States with $US49 billion.
In many affluent countries, government handouts add up to 40 per cent of farmer’s
income, with farmers in South Korea, Switzerland and Norway receiving two-thirds
of their income from taxpayers or consumer transfers. Average import tariffs for
farm and food products are 10 times higher than for manufactured goods, with many
products also drastically limited by quotas.
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3AECO - Free Trade and Protection
STUDENT ACTIVITY 2.4
The following article is an extract taken from the Australian Financial Review’s
Editorial of July 14th, 1999. Complete the questions which follow it.
Trade reform must proceed
The Prime Minister, Mr John Howard, is right to
complain bitterly to the Americans about their
treatment of Australian and New Zealand lamb. But he
was right to reject the inane suggestion from his Trade
Minister that Australia must call a stop to trade
reform until other countries catch up.
As the Prime Minister said, Australia has pursued
unilateral trade reform in its own economic interest.
The main reason for lowering Australia’s trade
barriers is to improve the Australian domestic
economy. If other countries also lower their barriers,
that’s a bonus, but it’s a small cherry on the cake.
Trade reform for the sake of the domestic economy
sounds counter-intuitive, but the point is easily seen
when it is applied to someone else. Take the
Europeans and their agricultural policy. For years
Australia has
been stressing that the EU would be better off if it
allowed its citizens to buy cheaper food grown in
Australia and the other agricultural exporting nations.
And of course it would. The Europeans are inefficient
food producers.
Their barriers to agricultural trade means they
waste a lot of scarce resources (investment
capital, skilled labour, etc.) producing something they
could get more cheaply from foreigners.
If instead they used those resources to produce the
things they make best (mainly manufactured goods
and services), everyone would be better off. We’d be
richer, obviously, but so would they. Indeed, they’d be
the main winners, with more jobs and higher real
incomes.
What is true for the Europeans is also true for us.
Australia’s tariff walls had diverted scarce resources
into industries that could never be competitive without
government support. After decades of high trade
barriers, the Australian economy became so weighed
down with inefficient industries that it had one of the
lowest productivity growth rates in the OECD. The
past decade of tariff reform has been an important
factor behind Australia’s improved productivity and
economic growth performance in the late 1990s.
It has also been an important factor in the rebirth
of Australia’s manufactured exports. Tariffs are a
hidden tax on exports. When tariffs restrict imports
they also cause the exchange rate to appreciate. The
overvalued exchange rate, in turn makes exports less
competitive. So, as Mr Howard says, Australia pulled
down the tariff wall because it was in Australia’s own
interest. We should wind down our remaining trade
barriers for the same reason.
Note: the treatment of lamb refers to the US imposition of tariffs on imported lamb from Australia and New Zealand to protect
US lamb producers
a) The countries of the European Union heavily subsidise their agricultural producers.
Explain how this helps European farmers.
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__________________________________________________________________________________
__________________________________________________________________________________
b) Who bears the cost of these subsidies? What are the opportunity costs?
__________________________________________________________________________________
__________________________________________________________________________________
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3AECO - Free Trade and Protection
c) Tariffs worsen economic inefficiency and hamper productivity growth. Explain.
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
d) Explain how reducing tariffs in Australia has helped manufactured exports.
__________________________________________________________________________________
__________________________________________________________________________________
__________________________________________________________________________________
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QUANTITATIVE FORMS OF PROTECTION
Embargo - a total ban on an imported product. Consumers can only buy the locally
made product.
Import Quota - a restriction on the quantity of a product imported. This forces up
the price of the product. Domestic producers can then put up their prices.
Other Non-tariff barriers - quality standards, local content rules, bureaucratic
barriers (red tape), quarantine restrictions.
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3AECO - Free Trade and Protection
STUDENT ACTIVITY 2.5
1. Below is a list of arguments against protection. Your task is to research the
arguments in favour of protection and list them in the column below in point
form (key words and phrases).
AGAINST PROTECTION
FOR PROTECTION
• Misallocation of resources - resources consumed
by protected industries add to competition in factor
markets → factor prices ↑ → costs of production higher
across economy → reduces competitiveness of
Australian goods + services on global + domestic
markets → lower economic growth.
• Higher prices for consumers – protection adds to
inflationary pressures. Import prices rise due to trade
barriers → prices of goods + services of protected and
unprotected firms rise (due to flow on effects of barriers
on production costs). Reduced consumer welfare due to
lower purchasing power + less choice. Exporters face
rising costs but can’t easily pass them on to their
international customers. Consumers can’t access and
benefit from factor advantages of other countries when
trade barriers exist.
• Redistribution of income away from workers +
producers in efficient and unprotected industries +
consumers to producers and workers in inefficient +
protected industries. Tariffs shift income to government
away from households and efficient firms.
• Retaliation - trading partners retaliate → less trade
takes place → lower welfare all round - export industries
are hurt when protection is used to shield importcompeting firms. Protection is self-defeating - damages
international relations and good will. eg. trade disputes
involving USA and China → affects other countries like
Australia. Reducing own protection measures (unilateral
trade liberalisation) → stronger position to put pressure
on other countries to do the same.
• Less innovation - protection removes incentives to
change + innovate. It removes the need to increase
efficiency and productivity. Competition is a driving
force behind change + progress → new products,
processes, methods + technology. Protection chokes
competition therefore stifles innovation and progress.
• Tax on exports - protection reduces imports → $A
appreciates (cet. par.) → X more expensive and
therefore less competitive.
• Protection - worsens poverty in poor countries because
they can’t get access to protected markets in rich
countries for their products.
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3AECO - Free Trade and Protection
2. The following article from the Australian Financial Review, 15-8-05, argues that
exploiting our comparative advantages is the path to improving Australia’s
international competitiveness. Read it and answer the questions.
More protection simply a recipe for disaster by Alan Mitchell
The federal government, the car industry and its
unions held a summit last week to discuss the threat to jobs
from low-wage producers. Industry Minister, Ian
Macfarlane rightly dismissed calls for a return to 1970sstyle industry plans, but the pressure now felt by the car
industry raises the question of how manufacturers in general
are going to cope with the onslaught of cheap competition
from China and the rest of Asia.
The answer is by doing more of what they have been
doing over the past two decades. For an individual firm or
industry, the test of survival usually is expressed in terms of
absolute advantage: are the Australian producers costcompetitive?
For many of Australia’s clothing manufacturers, the
answer has been no. As the Productivity Commission said in
a recent review of manufacturing, Chinese clothing workers
have caught up with Australian counterparts in terms of
productivity, but continue to be paid much lower wages.
However, the competitiveness or otherwise of our
manufacturers is really the result of Australia’s comparative
advantage. Australia has a comparative advantage in
producing a good if the “opportunity cost” of producing
that good is lower here than in other countries. By
opportunity cost, economists mean opportunity forgone to
produce something else with the same resources.
Comparative advantage can spring from many sources,
including differences in climate and technology, but the most
famous source of comparative advantage is a country’s
endowment of capital and labour. Australia, like other highincome countries, is relatively well endowed with capital,
including what economists call human capital, or skills.
China, on the other hand, has an abundance of labour, and
only a limited amount of capital (human or otherwise) per
worker.
The real reason Australian clothing manufacturers
could not compete with the Chinese is that the Australians
had to compete for workers against other Australian
industries where capital per worker, productivity and wages
are high. And they could not offset this high-wage disability
because they had already exhausted the scope for major
productivity gains.
Manufacturing basic clothing is not an industry for
Australia. If we stay in the rag trade, it will be at the high
skill end: high-fashion, low-volume clothing and high tech
industrial and defence apparel, etc.
A similar forecast can be made about the car industry.
Excess global capacity and high product development costs
have led to consolidation by the traditional manufacturers.
The six largest car companies now control 60 per cent of
global production. There also has been a shift to global
vehicle designs and a rationalisation of component
production.
At the same time, Australian producers have had to
work with less protection. Tariffs have fallen from 57.5 per
cent in the late 1980s to 10 per cent. Yet four Australian
producers have survived and one or two have even
prospered. How? First by raising productivity vehicle
production per employee has risen 50 per cent since 1990.
Turnover per employee in the component sector has
increased 90 per cent. At the same time, they have moved
upmarket.
The quality of Australian cars and components has
improved to the point where they are internationally
competitive. And the industry has become Australia’s sixth
largest exporter, competing with fellow subsidiaries to
supply their parent companies’ global markets. ...
Australia’s car industry, like its other manufacturers,
will survive by capitalising on our abundance of highly
skilled labour, by sourcing offshore components better made
in labour-intensive economies, by emphasising quality, by
investing in research and development, by adapting global
production techniques to small-scale production, and by
exploiting niche markets.
Unfortunately, this can be only be done by the
manufacturers themselves in the heat of the battle for
survival. Increasing protection is the surest way to deaden
the industry’s competitive instincts.
a) Explain the term ‘absolute advantage’ in your own words.
__________________________________________________________________________________
__________________________________________________________________________________
b) ‘The real reason Australian clothing manufacturers could not compete with the
Chinese is that ...’ . Read the full sentence again and explain the reason in terms of
opportunity cost.
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3AECO - Free Trade and Protection
__________________________________________________________________________________
c) How does protection ‘...deaden the industry’s competitive instincts’?
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3. Multiple Choice:
3.1. A reduction in a particular tariff will in general cause a contraction of output in the
industry previously protected by the tariff, followed by an economy-wide expansion of
output due to:
a) reductions in input prices due to improved resource allocation.
b) increases in the overseas demand for exports.
c) increases in the price of exports.
d) further misallocation of resources.
3.2. A country can use a tariff to produce:
a) an expansion of employment in the protected industry.
b) an overall improvement in the welfare of the consumers.
c) an improvement in the welfare of some producers at no sacrifice to others.
d) an increase in exports.
3.3. Protection of domestic industries:
a) encourages them to adapt to changing economic circumstances.
b) enables them to be sensitive to technological development and shifting
consumer tastes.
c) helps the maintenance of incomes in the protected industries.
d) supports them in competition in international markets.
3.4. Currently the only justification in Australia for tariff protection is that tariffs:
a) will stimulate exports to other countries.
b) provide an important source of tax revenue for the government in difficult
times.
c) encourage Australian firms to invest overseas and generate income from
profits made overseas.
d) reduce the loss of jobs in industries in the short term as they undergo
restructuring.
3.5. The political popularity of a tariff on imported goods that compete with products of
a well established domestic industry is:
a) surprising, since one would expect the political power of consumers to override
the interest of even a well-established domestic industry.
b) surprising, since one would expect the economic harm resulting from tariffs to
be well understood by voters.
c) not surprising, since such a tariff would generally benefit an easily recognised
interest group at the expense of uninformed and unorganised consumers.
d) not surprising, since the tariff enables domestic producers and consumers to
gain at the expense of foreigners.
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The next question refers to the diagram.
Price
S
S1
Pw
D
Q
0
Q1
Q2
Q3
3.6. If the world price is 0Pw and a government subsidy shifts the supply curve from S
to S1, then local producers will supply
a) 0Q1
b) 0Q3
c) Q1Q2
d) 0Q2
3.7. Arguments for reducing protection focus on:
a) mainly job growth opportunities in other sectors of the economy which aren’t
protected.
b) the allocative benefits of greater efficiency and productivity and boosting
international competitiveness.
c) achieving necessary structural change in order to prosper in a rapidly
changing, more integrated world economy.
d) all of the above.
Protection
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